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Microeconomic Theory of International Trade

CONCEPT OF PRODUCTION POSSIBILITY FRONTIER

The productive resources of the country can be used for the production of various alternative goods.

But since the resources that any country has been scarce, a choice has to be made between the alternative goods that can be produced. In other words, the economy has to choose which goods to produce and how much of that good to produce. In order to produce more of certain goods, the production of other possible goods has to be given up due to limited available resources.

What is production possibility frontier (PPF)?

The PPF is a graphical representation of two goods the economy can produce given the availability of necessary resources and technology. The production possibility curve graphically represents alternative production possibilities between two goods open to an economy.

Example:

Let us suppose that the economy can produce two commodities, cotton and wheat. We suppose that the productive resources are being fully utilised and there is no change in technology. The following table gives the various production possibilities.

Production possibilities

Sugarcane (in 000 quintals)

Wheat (quintals)

A

0

15

B

1

14

C

2

12

D

3

9

E

4

5

F

5

0

If all available resources in an economy are efficiently employed for the production of wheat, 15000 quintals of it can be produced and no quintals of sugarcane are produced. If, on the other hand, all available resources are utilized for the production of sugarcane, 5000 quintals are produced and no production for wheat takes place. These are the two extremes represented by A and F and in between, them are the situations represented by B, C, D and E. At B, the economy can produce 14,000 quintals of wheat and 1000 quintals of sugarcane. At C, 12000 quintals and 2000 quintals of wheat and sugarcane are produced respectively. As we move from A to F, we give up some units of wheat for some units of sugarcane. For instance, moving from A to B, we sacrifice 1000 quintals of wheat to produce 1000 quintals of sugarcane, and so on. As we move from A to F, we sacrifice increasing amounts of Sugarcane.

The above example clearly implies that more and more of one good can be obtained only by reducing the production of another good. This is due to the basic fact that the resources any economy possess are limited.

The following diagram illustrates the production possibilities of above table:

Assumptions of PPF

Consider the following assumptions of Production possibility frontier:

Two Goods: The first assumption of production possibilities analysis is that the economy produces only two goods. In that the economy actually produces thousands of different goods, this is a very unrealistic assumption.

Fixed Resources: A second assumption is that the economy has limited and fixed quantities of resources. This is a reasonable assumption, given the limited resources characteristic of the scarcity problem.

Fixed Technology: A third assumption is that the economy has a fixed level of technology. Technology is the information and knowledge that society has about the production of goods and services. At any given time, the economy has a certain level of technology. However, technology does increase over time.

Technical Efficiency: The last assumption is that resources are used in a very efficient manner. Technical efficiency means there is no waste in production, that the most physical output is obtained from the resource inputs.

characteristics of PPF

PPF slopes downwards: PPF shows various possible combinations of two goods that the economy can produce with the available resources and technology. On the PPF curve, the resources are assumed to be fully and efficiently employed, hence production of both the goods cannot be increased together. As resources are scarce, more of good X can be produced only with less of good Y. Due to the inverse relationship between the production of the two goods, we get a downward sloping PPF curve.

PPF is concave shaped: PPF curve is concave shaped because of increasing opportunity costs. This means that more and more units of good Y have to be sacrificed to gain an additional unit of good X. In the above-stated example of wheat and sugarcane, units of wheat sacrificed keep on increasing as more resources are employed in the production of sugarcane. Due to increasing opportunity cost, PPF becomes more and steeper as we move from points A to F.

CONCEPT OF OPPORTUNITY COST

The concept of opportunity cost in economics arises whenever an economic agent chooses between the alternative ways of allocating scarce resources.

Opportunity cost refers to the next best alternative forgone. An opportunity cost of a resource is the next high valued alternative of that resource.

Opportunity cost is a fundamental concept in economics and helps in making cost-benefit analysis of any project that is to be undertaken. This type of cost is not accounted in books of accounts as it is a part of economic cost rather than the accounting cost.

EXAMPLE 1

-Suppose if on a particular day, you spend both time and money to watch a movie, then you cannot spend your time reading a book or playing a video game at home at the same time. So if your next best alternative to watching a movie is reading a book, then your opportunity cost of seeing the movie is the pleasure foregone by not reading the book.

EXAMPLE 2:

- Suppose you have rs 20000 and you want to purchase one computer and a LCD TV. with Rs 20000 only in hand, you cannot have both. If you decide to purchase a computer, then the opportunity cost of choosing the computer is the cost of the foregone satisfaction (LCD TV).

OPPORTUNITY COST AND PPF

Relocating scarce resources from one good to another requires the knowledge of opportunity cost.

Opportunity cost helps in understanding what all is going behind a production possibility curve. Opportunity cost is thought of as how decisions to increase production of an extra unit of one good results in a decrease in production of another good.

The opportunity cost of a product is the alternative that must be given up to produce that product

As the production of a good is increased along a PPF curve, there will be increasing sacrifice in terms of reduction in production of the other good.For example, as the economy tries to increase the production of sugarcane ( along X-axis), it must sacrifice more wheat (along Y-axis). Thus, opportunity cost increases as more of a good are

The PPF curve gets steeper as more of sugarcane is produced, indicating greater sacrifice in terms of wheat production. The opportunity cost of producing more sugarcane is fewer wheat.

ABSOLUTE AND COMPARATIVE ADVANTAGE

The concept of opportunity cost and exchange play a very important role in helping to understand what economists argue that all countries can gain from international trade. There could be mutually beneficial gains from trade from an economic perspective. Therefore, it's important to understand when and how an economy can benefit from trading with other nations.

ABSOLUTE ADVANTAGE

-The absolute advantage refers to the differences in the productivities of nations. In other words, it refers to a country having the advantage of being more productive or efficient in producing a particular good or service. A country with a comparative advantage in a good or a service can produce more amount of them with given inputs than any other country.

-Absolute advantage only considers productivity and does not take any measure of cost into account. It only implies that a country can produce a good at a lower cost.

COMPARATIVE ADVANTAGE

Comparative advantage refers to the differences in opportunity costs. In other words, it refers to the ability of a country to produce a particular good or service at a lower opportunity cost than any other country.

The concept of absolute advantage does not tale cost into account. Thus, it is useful to have a measure that takes account of economic costs. Economic costs are known as opportunity cost, which is the total amount that one must give up in order to get something. A comparative advantage occurs when one country can produce a good or service at a lower opportunity cost than other countries.

UNDERSTANDING THE ABSOLUTE AND COMPARATIVE ADVANTAGE THROUGH AN EXAMPLE:

Country

Pants

Laptops

East

200

20

West

100

5

Consider the case of two fictional countries, which we will call east and west. East is highly developed with skilled workers and modern capital equipment. West is much poorer; its workers are generally unskilled and have little capital equipment to aid them in production.

Assuming that the two countries can produce only two goods, laptops and garments (textiles). The developed country is more productive than the less developed country at producing both laptops and garments.

Assuming that in the east, 100 hours of labor can produce either 20 laptops or 200 pants. In the west, 100 hrs of labor can produce only 5 laptops or 100 pants. From this, it is clear that east is more productive than west. In this situation, east is said to have ABSOLUTE ADVANTAGE in producing both the goods.

In the east, the opportunity cost of producing 200 pants is 20 laptops. In contrast, the opportunity cost of producing 200 pants in the west is only 10 laptops. The opportunity cost of producing more pants is lower in the west than it is in the east. Thus, here we say that west has a COMPARATIVE ADVANTAGE in producing garments. west is relatively more efficient in the production of pants than east is.

RICARDIAN TRADE MODEL

Introducing the model

The Ricardian model provides the introduction to the international trade theory. It is the most basic model of trade between two countries, two goods and one factor of production i.e. Labor. Differences in the relative productivity of labor give rise to international trade across countries. This model provides useful insights into the concept of comparative advantage and gains from trade. The theory of comparative advantage as formulated by David Ricardo is called comparative cost theory and is regarded as the classical theory of international trade.

The Labor theory of value forms the base for the Ricardian trade model. According to Labor theory of value, the economic value of a good or service produced is determined from the total amount of necessary labor required to produce it.

The model tries to explain the difference in the comparative advantage on the basis of technological difference across nations. Ricardo's trade model stresses the point that international trade is beneficial for all the nations engaging in it. According to this model, even an underdeveloped country will benefit from international trade.

In this trade model, technological differences between two countries are the main reason for countries engaging in trading activities. This is a supply-side difference between two countries involved in international trade.

The Ricardian model shows the possibility of an industry in a developed country competing against an industry in a less-developed country, even though the LDC industry pays its workers much lower wages comparatively.

ASSUMPTIONS OF RICARDIAN MODEL OF TRADE

1) PERFECT COMPETITION: The trade model assumes perfect competition prevailing in the market. This assumption implies that there are many firms in the market and thus take price as given or exogenous. The output is homogeneous across all firms, there is free entry and exit of firms in response to profits and information is perfect.

2) TWO COUNTRIES: The model assumes that there are only two countries in the world. This is used to simplify the analysis of the model.

3) TWO GOODS: Only two goods are produced by the countries. The model assumes a barter economy. This means that no money is used to make transactions. Instead, for trade to occur, goods must be traded for other goods.

4) ONE FACTOR OF PRODUCTION: Only labor is used as a factor of production to produce each of the goods. The factor is homogeneous and can freely move between industries.

5) GENERAL EQUILIBRIUM: The Ricardian model is a general equilibrium model. In economics, a general equilibrium arises when prices of goods, services, and factors are such that supply and demand equalize in all markets simultaneously.

6) TRANSPORTATION COST: The trade model assumes that the goods can be transported between the countries at zero cost.

7) There are constant returns to scale in the production of the two goods. Also, there is the full employment of the available resources in the best possible way.

The Ricardian trade model determines supply-side differences (technological differences) as the basis of international trade. Demand is not the basis of international trade in a Ricardian model of trade. However, demand plays a crucial role in the determination of the terms of international trade in the Ricardian model only after opening up of trade between the two countries.

RICARDO'S EXAMPLE

The essence of international trade, according to Ricardo is in the comparative difference in cost. It is beneficial for the country with an absolute advantage in the production of both the commodities, to specialise in the production of that commodity in which it has a greater comparative advantage.

Given the above assumptions, Ricardian model tries to explain the comparative cost difference theory by taking an example of England and Portugal as the two countries and wine & cloth as the two goods. The cost is measured in terms of labor hours. The principle of comparative advantage in terms of labor hours as shown in the table below:

One unit of wine

One unit of cloth

England

120

100

Portugal

80

90

Clearly, Portugal requires fewer hours of labour for both wine and cloth. One unit of wine in Portugal is produced with the help of 80 labour hours as compared to 120 labour hours required in England. In the case of cloth, Portugal requires fewer labour hours than England. From this, it could be argued that there is no need for trade as Portugal produces both commodities at a lower cost. Ricardo here tried to prove a country can gain by specializing in the commodity in which it has a greater comparative advantage.

Now in order to see if there is any possibility of any mutually beneficial trade, we need to analyze the opportunity costs of producing cloth and wine.

In order to calculate the opportunity costs, we need to check how much of one good could have been produced if we divert from producing a unit of other good.

For example, a unit of cloth costs 100 labor hrs to produce in England. If these 100 hrs are diverted to the production of wine, then England could have produced 5/6 or 0.66 unit of wine{(100hours/unit of cloth) /(120 hrs/per unit of wine) = 10/12 or 5/6 unit of wine}.

This means that for every unit of cloth produced in England it is giving up a little less than a unit of wine (5/6 units)

Following table shows the opportunity costs of wine and cloth calculated in the same manner as shown above:

Opportunity costs

Wine

Cloth

England

6/5 unit of cloth

5/6 unit of wine

Portugal

8/9 unit of cloth

9/8 unit of wine

In order to determine the pattern of trade, we need to analyze the opportunity costs of the two commodities shown.

A country will have a comparative advantage in the production of a good if it has the lower opportunity cost as compared to the country with who it is trading.

England has the comparative advantage in the production of cloth since its opportunity cost 5/6 unit of wine as compared to Portugal’s 9/8 unit of wine.

Also, we can see that Portugal has a comparative advantage in the production of wine since its opportunity cost of producing wine is 8/9 unit of cloth as compared to England's 6/5 unit of cloth.

Thus, in the above Ricardian example, Portugal can specialize in the production of wine while England can specialize in the production of cloth. Portugal and England can trade among themselves where they export that good where they enjoy comparative cost advantage and import that good from which they suffer cost disadvantage.

HECKSCHER OHLIN MODEL

The Ricardian model of trade did not explain clearly the reason for the differences in comparative costs of producing various commodities between different countries, though it determined differing comparative costs as the basis of international trade. Heckscher-Ohlin Model of international trade explains the real cause of this difference in comparative costs.

According to Hecksher-Ohlin model, trade results on account of the different relative price of different goods in different countries. The difference in relative price is due to the difference in relative costs and factor prices in different countries.

The differences in factor prices are due to differences in factor endowments in different countries. /thus international trade occurs because different countries have different factor endowments (i.e. capital & labor).

ASSUMPTIONS OF HECKSCHER-OHLIN MODEL

There are only two countries involved.

Each country has two factors of productions i.e. Capital and labor.

Each country produces two commodities.

There are no transportation costs for carrying goods between countries.

There is perfect competition in both factor market and goods market.

There is the full employment of resources in both the countries.

There are constant returns to scale i.e. All production functions are homogeneous of degree 1.

The production function remains same in different countries for the same commodity.

UNDERSTANDING THE MODEL

The underlying forces behind differences in comparative costs are:

The different countries have different factor endowments.

The different goods require different factor-proportions for their production. This implies that different goods require different proportions of capital and labor for their production.

Some countries possess relatively more capital and some relatively more labor. The factor which is relatively abundant in a country will tend to have a lower factor price while the factor which is relatively scarce will tend to have a higher price.

Given the above endowments of the two factors, capital will be relatively cheaper in North while labor will be relatively cheaper in South. This can be shown is symbolized form as:

(K/L)n > (K/L)s since (Pk/Pl)n < (Pk/Pl)s

The differences in factor productions needed for the production of different commodities account for differences in comparative cost of producing commodities.This results in different market prices of different commodities in different countries.

The country North has abundant capital and the relative scarcity of labor. Thus, North will enjoy a comparative advantage by specialising in the production of capital-intensive commodities and will import labor-intensive {(Pk/Pl)n < (Pk/Pl)s}.

A labor-intensive country South with a scarcity of capital will have a comparative advantage in specialising in the production of labor-intensive commodities and export those commodities in exchange for capital-intensive commodities. {(Pl/Pk)s< (Pl/Pk)n}.

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